Weekend Reading for Financial Planners (August 17-18)

Executive Summary

Enjoy the current installment of "weekend reading for financial planners" – this week’s reading kicks off with an announcement by the CFP Board at their recent Program Directors conference that they intend to offer a "massive online open course" (a "MOOC") to help draw new potential professionals into the field of financial planning (and ultimately to pursue their CFP designation). Also in the news this week was the latest data from Schwab Advisor Services on advisor mergers and acquisitions, showing a notable slowdown in activity in the first half of 2013, and a look at the new investment data solution YCharts that is aiming to become the Bloomberg terminal for advisors (at a more reasonable price point, and with Morningstar as one of its venture capital financiers)!

We have a few technical articles this week, including a discussion about Social Security benefits estimates and the fact that they don’t take into account the "Windfall Elimination Provision" for those who spent a period of years working in a job that wasn’t covered by Social Security, a look at a recent IRS ruling on Self-Cancelling Installment Notes (SCINs) that may have a chilling effect on their use as an estate planning technique, and a Journal of Financial Planning article that provides a good overview of some of the research on asset location and determining after-tax asset allocation decisions.

From there, we have a few practice management articles this week, including two compliance-related articles: one on the importance of business continuity and disaster recovery plans, and the other on why the custody rule matters for financial advisors and how to avoid or manage it (hint: just using a third-party custodian is not enough). There’s also an article from Bob Veres envisioning how financial planning firms may shift in the future, with a less asset-centric focus and more attention to the human capital aspects of planning for clients.

We wrap up with three interesting final articles: the first is from marketing guru Seth Godin, about the idea of "if there are people who are an accident just waiting to happen… what’s the opposite?" suggesting the answer is to be "formidable" and what it takes to live up to the label; the second is from the blog of Stephen Wershing, and makes the excellent point that just because advisory firms are growing doesn’t mean they’re good at marketing, when in truth they may just be good at selling; and the last from practice management consultant Angie Herbers, suggesting that in the end we may be attaching far too much stigma to the decision of advisors to "downsize" their firms and that ultimately success is about how the business owner measures it, not what everyone else thinks. Enjoy the reading!

(Editor’s Note: Want to see what I’m reading through the week that didn’t make the cut? Due to popular request, I’ve started a Tumblr page to highlight a longerlist of articles that I scan each week that might be of interest. You can follow the Tumblr page here.)

Weekend reading for August 17th/18th:

CFP Board Extends Reach With Massive Online Course – In an effort to grow the pipeline of future financial planners, the CFP Board this week announced that it had entered into a verbal agreement with the University of Illinois to offer a "massive online open course" (also known as a MOOC) in financial planning and financial literacy in 2014. The goal is to draw tens of thousands of students to the field of financial planning (MOOCs are typically free and offered entirely online to anyone who wishes to enroll) and potentially stir their interest in pursuing the profession, with the hopes that they will then enroll in a CFP Board registered program and ultimately obtain the CFP certification. The initiative appears to be coming in response to the fact that the number of CFP certificants is growing, but not at the pace that the CFP Board would like, as last week’s CFP Board Program Directors conference also noted with concern that a large number of students are going through CFP Board registered programs but are not following through to sit for the exam and enter into the profession; the lack of follow-through is notable, as more than half of the educational institutions now offered the CFP certification curriculum are doing so at the bachelor’s and/or graduate degree level. While the CFP Board indicated that it intends to further study and analyze why students are not following through to obtain the CFP mark after their graduation, the MOOC appears to be a simultaneous effort to increase the inflow of prospective students as well.

Big Drop In RIA Deal Flow Despite Strong Organic Growth – The numbers are in on mergers and acquisitions amongst RIAs in the first half of 2013 from Schwab Advisor Services (which attempts to track all deals in the industry with more than $50M of AUM), and the results show a significant slowdown in activity, with only 18 completed transactions totaling $15.4B of AUM (and only 5 of them were in the second quarter), which is the lowest pace on record since 2008. By contrast, the first half of 2011 had 27 deals totaling $20B of AUM, and it was 25 deals for $36B in AUM in 2012. Schwab suggests that the slowdown may be because the steady growth of the markets has reduced the desire for advisors to sell, as despite the slowdown in M&A activity the RIA segment continues to be the fastest growing overall, with recent Aite Group results showing that RIAs anticipate more client growth than wirehouse advisors. Notwithstanding the lack of sellers, though, there certainly remains a strong base of prospective buyers, as Schwab’s recent benchmarking survey found a whopping 25% of all firms with $100M to $1B of AUM are actively looking to acquire another firm. For the time being, though, it appears to remain a seller’s market, despite year after year of demographics-based predictions that there should be a selling wave of baby boomer advisors starting any year now.

Morningstar Takes A Big Stake In A Startup Gunning To Be The Bloomberg For RIAs – From RIABiz, this article looks at the recent infusion of venture capital dollars into YCharts, a new service that is aiming to be the "Bloomberg" for RIAs, given the rising need from RIAs for research data to craft portfolios but the rather high $20,000/year price point for Bloomberg terminals (YCharts is only $50/month for the "Gold" version and $200/month for "Platinum"); YCharts also has some appeal for being a purely online-based tool, unlike the Bloomberg terminal that typically requires a physical machine. The tool is entirely online, and although it’s not quite perfectly real time in some of its data – YCharts is about 10 to 15 minutes behind Bloomberg – for RIAs that tend to be focused more on wealth management than real-time stock trading, that may not be an issue. Notably, the tool could also put a potential dent in the advisor use of Morningstar, though Morningstar itself doesn’t appear to be concerned, as it’s actually one of the investors with $3 million of its own capital and has indicated it views YCharts as more complementary than competitive. Thus far, that seems to be an accurate characterization, as there’s actually not a lot of overlap in the services, given that Morningstar is primarily focused on funds, while YCharts focuses on individual equities and also a great deal of economic and financial information. Ultimately, it remains to be seen whether some additional synergies might form between the two companies.

Don’t Be Fooled By Social Security Benefits Estimates – This article by Mary Beth Franklin of Investment News provides an important reminder that advisors should be wary of placing too much blind faith in the Social Security benefits estimates that clients bring in. The issue is that those clients who worked for a period of time in jobs where the employer did not withhold for Social Security taxes, and who will receive a pension from that "non-covered" job, may have their Social Security individual retirement benefits reduced under the so-called "Windfall Elimination Provision" (WEP). The WEP reduction applies by altering the Social Security benefits calculation formula; normally, workers receive a benefit equal to 90% of their first $791 of average indexed monthly earnings, plus 32% of the next $3,977 and 15% of the rest (up to the Social Security wage base cap); with the WEP, that 90% of the first $791 of earnings is reduced to only 40%. As a result, clients can lose up to $395.50 in benefits, though the adjustment is reduced for those who have at least 21 years of "substantial" earnings (more than $21,075/year) under Social Security, and the WEP doesn’t apply at all after 30 years of substantial earnings. The purpose of the WEP is to recognize that the high income replacement formula for the initial amount of earnings is intended to provide a higher income replacement for low-income workers, not for those workers who appear to be low income because many years of their earnings were excluded from the Social Security system (in a non-covered job with its own pension). For further information on the WEP, including a calculator to estimate the adjustment benefit (and also information on the Government Pension Offset rules that similarly reduce spousal and survivor benefits for those who worked in non-covered jobs) see the Social Security Administration’s informational site.

IRS SCINs A Cat – On Wealth Management, this article discusses the recent CCA 201330033 ruling from the IRS regarding the use of Self-Cancelling Installment Notes (SCINs) and may significantly curtail their use as an estate planning technique. The basic idea of a SCIN for estate planning is that the client sells property to another family member or a trust, in exchange for a ongoing note payments that are cancelled if the client passes away during the term. Of course, the risk that the client may pass away means the loan payments will be slightly higher (to account for the risk premium), but if the client doesn’t survive then property can potentially be transferred for far less than its original cost (and since payments cease at death, nothing is included in the decedent’s estate, either). Of course, this allows for a self-selection bias – those who don’t believe they’ll live a very long time are incentivized to try the SCIN strategy – and the problem was exacerbated by the fact that most practitioners believed it was reasonable to use the IRS-published mortality tables that ignore the client’s actual health (unless there’s a terminal condition); thus, anyone whose health was "poor" but not "terminal" could enjoy potentially huge estate tax savings by transferring property using a SCIN and ultimately passing away far short of the assumed life expectancy, and the strategy worked even better in today’s environment where the required Applicable Federal Rates for setting an interest rate on the note are also low. In the ruling, though, the IRS declared that it was invalid to rely on the Section 7520 or other mortality tables alone to set a risk premium on the payments for the note; instead, the IRS declared that in the future, SCINs should be valued based o the medical history of the transferor at the time of the transfer (especially if any medical conditions would impact expected longevity). As a result, the note payments for SCINs may need to be significantly higher in the future, as failing to set payments and the associated risk premium property would mean the fair market value of the SCIN is less than the property transferred, which would result in a gift tax liability for an improperly valued SCIN transfer, and in the future practitioners should seriously consider obtaining an actuarial valuation of the client’s life expectancy to properly calculate the note payments (though with such true and fair valuation, it’s not clear how popular the SCIN technique will be anymore).

A Scenario Based Approach To After-Tax Asset Allocation – This article from the Journal of Financial Planning tackles the issue of asset location, and how to adjust asset allocation given the fact that different types of accounts have different tax treatment that in turn impact the ultimate after-tax value of the account. The basic issue is that having $1,000,000 of stocks in an IRA and $1,000,000 of bonds in a brokerage account has a different after-tax-adjusted asset allocation than the same investments held in opposite accounts; thus, decisions about which accounts to hold which types of assets for tax purposes can impact the asset allocation itself, forcing a new allocation of assets, which in turn can require an(other) adjustment of the asset locations, etc. Computationally, this circular calculation can be refined and optimized to a final outcome, but the authors here suggest an alternative, "scenario based" approach to analyzing the issue, especially given that the results of an optimization process can be highly sensitive to the tax and investment assumptions used (which is problematic given their uncertainty), and the difficulties of client perception (which we might technically understand how to tax-adjust different types of accounts, it may still be highly UNintuitive for clients to tell them that having $1,000,000 of stocks (in one type of account) and $1,000,000 of bonds (in another type of account) is NOT a 50/50 allocation, and it’s even messier when trying to report tax-adjusted performance). The scenario-based approach here is essentially just a simplified approach, where the advisor starts with one series of potential allocations (acknowledging future tax liabilities, potential tax rates, expected future cash flows, etc.), shows the client some information about the statistics and sensitivity of those options, and then helps the client select one, without the circular optimization calculations discussed earlier. While some might argue this oversimplifies what ultimately are material optimization issues, the authors make good points about the practical challenges of implementing a robust after-tax-adjusted analytical structure, and at a minimum provide some good food for thought about the issues to be considered.

Regulators Renew Focus On Business Continuity, Disaster Recovery Plans – In Investment Advisor magazine, compliance attorney Tom Giachetti discusses an area receiving increasing scrutiny from regulators these days: business continuity and disaster recovery (also known as "BC/DR") plans. Apparent regulators have even been targeting advisors in certain geographic areas prone to natural disasters and probing whether those advisors have BC/DR plans that would be sufficient to protect advisory clients from the risk of a business interruption. Of course, the matter isn’t just one of protecting clients (though a good BC/DR plan is necessary to fulfill fiduciary obligations); having a good BC/DR plan can also be essential for an advisory firm to actually survive a genuine business interruption in the first place. Unfortunately, though, while the regulations generally require that advisors have a BC/DR plan, there’s little guidance about what actually constitutes an effective plan. The general view is that an effective plan should thoroughly assess any/all risk exposures and their potential impact, be consistent with the firm’s level of sophistication, have adequate infrastructure to support implementation, and engage in routine testing to ensure that the BC/DC plan will protect the firm as intended. The BC/DR plan should also be regularly reviewed and maintained to ensure that it evolves with the needs of the business and changing regulations. Arguably, many advisors find themselves in a somewhat more robust BC/DR position as advisory firm tools migrate to the cloud, removing them from the scope and risk of local disasters that the advisor might face. Nonetheless, the reality seems to be a rising level of scrutiny in this area that advisors should be cognizant of.

The Custody Rule: It’s Not Just for Custodians – Continuing the regulatory theme from the Journal of Financial Planning, this article takes a deep dive into Rule 206(4)-2 of the Investment Advisers Act of 1940, also known as the "custody rule" for RIAs, which the SEC is increasingly scrutinizing these days in its examination priorities after finding a large number of RIAs are not properly complying with the rule. The technical definition is that custody means "holding, directly, or indirectly, client funds or securities, or having any authority to obtain possession of them" and the common perception amongst RIAs has been that as long as there’s a third-party custodian involved, that the firm doesn’t face any of the SEC custody rules. In reality, though, there are many seemingly minor scenarios that can result in custody issues for advisors. For instance, if a client mails the advisor a stock certificate and the advisor immediately forwards the security certificate to the custodian, the advisor is deemed to have had custody; instead, the proper treatment is to return stock certificates to the client and have them send it to the custodian directly. Another "surprising" scenario for many advisors is that having access to a client’s username and password for an investment account can also be deemed custody, if the advisor’s access could allow withdrawal of client funds from the account (the mere ability to make such a transfer is custody, regardless of whether the advisor ever tries to do so); similarly, if the advisor or any supervised person under the advisor is trustee of a client’s trust account held at the custodian, it is also deemed custody, because the advisor-as-trustee could write checks to him-/herself or take a withdrawal from the account (even if the advisor never does). So what happens if the advisor does have custody? It’s not illegal, but having custody requires the advisor to use a "qualified custodian" that separately maintains client assets, and independent sends clients statements at least quarterly, and the client must sign off regarding the relationship. The bigger issue of the custody rule, though, is that advisors with custody are required to undergo a surprise examination by an independent public account on an annual basis to verify client funds. Notably, there is at least one exception to this last rule; while even having the right to deduct advisory fees from a client’s account can trigger custody, if the advisor’s custody is solely for authority to draw advisory fees the advisor is not required to face surprise examinations to obtain an independent verification of client funds (though other client custody disclosures still apply). The bottom line: as an advisor, custody is permitted, but don’t take custody unless you really intend to maintain custody of client assets, and follow all of the associated obligations and responsibilities.

Envisioning The Planning Firm Of The Future – On Advisor Perspectives, Bob Veres shares some thoughts on where the financial planning value proposition may be going in the future, courtesy of an interview with financial planning pioneer Richie Lee, who has long been ahead of the curve (he was one of the early adopters of the AUM business model and was operating on a fee-only basis before the term was even coined). So where do Veres and Lee see the profession going? Lee starts by noting that the entire evolution of the profession thus far can be seen as the devolution and breaking apart of the traditional wirehouse model, where the in-house mutual funds because the no-load fund industry, the research department became Morningstar and Lipper, the proprietary trading desk turned into outside hedge funds, and the standalone "broker" supported by all the various now-external components because the RIA. The point being that the industry hasn’t actually evolved as far as some suggest; it’s simply re-arranged the structures a bit and re-aggregated the same array of services that previously existed in wirehouses, just reassembled in a more independent environment. Ultimately, though, Lee suggests that eventually planners really will materially shift the model away from managing the client’s assets and towards managing the client themselves, in an environment where the advisor must fully adapt to the client’s needs. This kind of model would allow advisors to shift focus from trying to provide value through incremental investment returns to more client-behavior outcomes like helping them to save more (which ultimately may have far greater financial impact anyway); Lee also sees a rising focus on human capital as the advisory profession shifts in this direction. Ultimately, Lee suggests that advisors will have to look at helping clients with four different types of "capital" – their financial capital (financial assets and investment accounts), their human capital (earnings potential), their fulfillment capital (money allocated to spend on things we want and enjoy), and their shared capital (philanthropic endeavors). When clients focus too much in one area, we label them accordingly (human capital centric is a workaholic, financial capital centric is a miser, etc.); the purpose of an advisor in this model will be to help clients balance amongst all four areas.

Choosing To Be Formidable – From the blog of marketing guru Seth Godin, this article raises the interesting question: "You’ve met people who are an accident just waiting to happen… what’s the opposite of that?" Godin’s answer is someone who is "formidable" – someone to be reckoned with, not a person who has all the answers (because no one does) but someone for whom the magic seems waiting to happen. Being formidable is what separates out the star quarterback, the star CEO, the start business partner or potential employee. What does it take to be formidable? Godin suggests that it comes down to two key elements: the skill to understand the domain, do the work, communicate it, lead, and show mastery; and the care and passion to see it through to the end despite the inevitable failures that will rise along the way. So the next time you’re thinking about a potential business partner to work with or employee to hire, consider whether they have the skill and care necessary to be formidable.

The Triumph Of Selling Over Marketing – From the blog of Stephen Wershing, this article makes the important point that just because an advisory firm is consistently getting new clients doesn’t mean it is good at marketing. In many cases, the reality is that the firm is bad at marketing, but good at selling. Why does it matter as long as clients are coming in? Because relying on selling alone makes you work harder and puts the business in a riskier position, because selling is purely one-on-one, which means it’s not growing unless the advisor is constantly out hitting the streets. In addition, when a firm is selling-centric, it has a tendency to promise clients and tailor the messaging to whatever the clients want/need… which may get people in the door, but results in a less efficient and ultimately less profitable business. The problem is even worse from the business valuation perspective, because a firm with great founding salespeople but no systematized marketing will find its growth grinding to a halt as soon as the founders step away, which can drastically curtail what a buyer will pay. Of course, Wershing notes that ultimately selling is not bad; in the end, the business cannot succeed without someone being able to sell and get clients to sign on. But without a marketing one-to-many approach that builds a brand and reputation that gets people interested in having the selling conversation, the growth of the business and especially its ability to grow beyond its founders are limited. So it’s not about walking away from the great selling the business may be doing, but recognizing that ideally those sales should be happening pursuant to a marketing plan that brought those clients in the door in the first place.

Retreat, Hell! Downsizing Need Not Be A Dirty Word For Advisors – From the ThinkAdvisor blog, practice management consultant Angie Herbers tackles the sticky issue of advisors who choose to downsize their firms, in a world where the industry media constantly trumpets the concept of "bigger is better" and harps on how "lifestyle firms are not very valuable." Noting that our culture seems to have a penchant for celebrating winners and attaching a stigma to anything that looks like retreating, Herbers points out that many business owners may be growing – or at least, trying to grow – their businesses to the point of making themselves unhappy, all to pursue a goal they don’t really believe in anyway because they already could be happy with the money they’re making. And in fact, Herbers finds that establishing the actual plan to downsize a business isn’t that hard; there are some difficult decisions to make, but the plan to "retreat" can certainly be crafted and executed. The problem Herbers finds in practice, though, is that the psychological challenges of being perceived as "retreating" are the greatest difficulty to overcome, with fears of how clients, the community, friends, and other advisors will view the decision to downsize, and whether that will give off the perception of having failed. Yet in the end, if the people who matter – in the case of the example in the article, the advisor’s family and clients – will understand, and it ultimately will make the advisor happier, then perhaps it’s time to give the plan to retreat more serious consideration. As Mark Tibergien has been known to say, "every business owner must have a personal definition of success" and ultimately, that’s the only one that really matters.

In the meantime, if you’re interested in more news and information regarding advisor technology I’d highly recommend checking out Bill Winterberg’s "FPPad" blog on technology for advisors. You can see below his new Bits & Bytes weekly video update on the latest tech news and developments, or read "FPPad Bits And Bytes" on his blog!